February 20th, 2012
by Jeff Miller
Since the start of the Great Recession there has been little reason for enthusiasm about the US housing market. The home construction industry and related sectors have been a continuing drag on the recovery.
In my circle of friends I know of several first-time home purchases in the last couple of years. I was reminded of this last night when visiting my niece and her husband, seeing their beautiful new urban home and enjoying a wonderful "Restaurant Week" dinner at a place new to us all. It is too easy for us stodgy old analysts to forget that successful young people want their own homes. For them, the time to buy is now.
Regular readers know that I embrace the illustrative power of the anecdote, but I live on data. Taking a look at this week's calendar, I expect more media attention to the prospects for improvement in housing.
With an open mind, no specific positions, and a multi-year record of skepticism on this sector, I am receptive to the question: Is it time for a turn in housing?
I'll look at this more deeply in the conclusion, but first, our regular look at the news and data from last week.
Background on "Weighing the Week Ahead"
There are many good sources for a comprehensive weekly review. You cannot read all of them. It is actually possible for your work to be counter-productive as I tried to explain in Read a Lot, Get Squat.
Instead of trying to drink from a fire hose, why not be more selective?
I single out what will be most important in the coming week. My theme is an expert guess about what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.
Unlike my other articles at "A Dash" I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put the news in context.
Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!
Last Week's Data
Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:
- The news is market-friendly.
- It is better than expectations.
A valued reader, noting the high unemployment levels, asked how I can ever write about employment as "good." I agree that we are far below what is needed for economic health and general prosperity, but that is not my mission. I am explaining how events will be interpreted by the market. You might disagree on political or policy grounds, but that is not the subject. When the news is "less bad" it is market-friendly.
There was some very good news this week.
- Initial jobless claims. This is important data, more current than most. The decrease in initial claims encourages us that the employment picture continues to improve. There is a lot of weekly noise, but the widely-followed four-week moving average is also very good. Ed Yardeni puts this in perspective, also questioning the PIMCO meme of the "new normal." He thinks it is the real normal, and you should read his thoughts.
- Sentiment is more bearish. In the world of investing, this is bullish. Go figure! Here is the chart from The Bespoke Investment Group.
- Leading Indicators are stronger. This is the Conference Board report, better despite the umpteenth adjustment. See Steven Hansen for a thoughtful analysis of this data series
- Congress managed to extend the payroll tax cuts. Everyone is claiming credit.
There was some bad economic news last week.
- Greek debt is even worse than we thought. The IMF has an update. See Calculated Risk for some helpful analysis.
- Fed POMO operations will be less aggressive. As regular readers know, I completely disagree with the POMO interpretation of the market. There is no logical connection. The charts are sloppy in starting and ending points. This source (HT Charles Kirk) is guilty on all counts, but I present it because it has had a major effect on traders. Self-fulfilling prophecy?
- Inflation is a little hotter than we want. This is a tricky topic, since the Fed wants to see inflation of about 2% on PCE. The choice of the PCE as the index dates back to the Greenspan days. It is a more accurate read of what people buy, avoiding many of the housing issues, and it is less volatile. It has been the Fed choice even when the inflation rate was higher than the CPI. Doug Short does a great job of explaining this, including his matchless charts. Here's one:
The respected folks at the Gallup Poll report that employment looks much worse as of mid-February. I saw the interview on CNBC from my hotel room in Seattle, but I want to investigate further. Here is the Gallup chart:
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
- The St. Louis Financial Stress Index.
- The key measures from our "Felix" ETF model.
- An updated analysis of recession probability.
The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.
This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain the link to the C-Score next week. (I now that I am behind schedule on this, especially with last week's travel and options expiration. This is important, but not urgent. The message is comforting.) The second is the Super Index. You can read more about it in this article, which is merely an introduction, and also my WTWA from three weeks ago. It reflects extensive research and testing, and is well worth monitoring. (The Super Index includes the ECRI approach). I am going to do a complete review of the work very soon. Meanwhile, I think it is important enough to watch every week.
The team working on recession forecasting and the SuperIndex continues to produce work that is absolutely first-rate. They are generating a suite of measures with differing time frames. For the investment world the key question is how much notice do we need? Here is a great answer:
Assume an investor is following a business cycle expansion buy-and-hold strategy, where the aim is to remain vested in the stock market for as long as possible before the onset of recession. Any defensive action longer than 4.8 months on average before a recession is going to be counterproductive for him or her. Think about this – in the 4.5 months since ECRI's recession call the stock market has rallied more than 22%. Is that counterproductive enough for you?
Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. We voted "Bullish" this week.
[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
This a light week for A-list economic data. It is a short week, influenced by the effect of last week's options expiration.
The initial claims series is the single most important report to watch right now, and we'll have an update on Thursday. There are revisions to Michigan confidence (Friday), and also some housing data, which might grab the focus.
Europe news is a wild card, but I see less concern and more emphasis on the US economy.
I monitor news and economic data every day in my diary at Wall Street All Stars (subscription required, but I have some membership discounts available for my readers).
Trading Time Frame
Our trading accounts have been 100% invested since December. Felix caught the current rally quite well, buying in on December 19th. There are now many solid sectors in the buy range. The overall ratings have improved, helping us to stay invested while many have been in denial for the entire rally. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated. Felix has been more confident than I have been on the trading time frame. This illustrates the importance of watching objective indicators instead of headlines.
Investor Time Frame
Long-term investors should be aware of the rapid decline in the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," and is declining further. This sort of decline has been a good time to buy stocks on past occasions. Worry is still high, but has now declined to a more comfortable level.
Even though stock prices are higher than in October, the risks are much lower. I am increasing position size for risk-adjusted accounts. (We cut back by about 30%). I am also looking more aggressively for positions in new accounts.
Our Dynamic Asset Allocation model is still very conservative, but starting to change into equities. For several weeks I have joked that it is rather like the Nouriel Roubini of our methods. Dr. Roubini is now becoming more bullish. There is nothing wrong with this! There are many successful market strategies. The risk/reward balance is a personal matter.
To summarize, we have become much less conservative in all of our programs, There is still risk, but as our indicators become more positive, we can and should become more aggressive. For new accounts we are establishing immediate partial positions, using volatility to buy favored names and selling calls for those in the Enhanced Yield program. This program continues to work very well, meeting the objectives of conservative, yield-oriented investors. It follows our key precept:
Take what the market is giving you.
I have been repeating this each week, because it is by far the most important message. It is better than trying to time the market. You can buy great dividend stocks at reasonable prices with the chance to sell call options at inflated prices. If the stocks do nothing, you can still get almost 10% per year from dividends and call premiums.
This does not work for those selling long-dated calls. It requires some active management, selling calls with a month or two before expiration to capture the most rapid time decay.
The Final Word on Housing
I do not have a strong personal feeling on housing. I understand the need to work off the inventory of abandoned homes and to deal with foreclosures. This is the widely-cited shadow supply. I know also that there is shadow demand from new families and people unwillingly living with parents.
Housing demand is linked to perceived affordability and employment. Here are some sources that we should all consider:
- Building Permits show increasing strength. This is a favorite indicator for me. Steven Hansen does a nice, in-depth look at the growth trend.
- Affordability of housing requires looking at both down payments and monthly payments. Check out The Bonddad Blog for a good analysis of both.
- Hard Data on Construction has improved, despite some builder confidence surveys (via Calculated Risk).
And finally, the conclusion from Calculated Risk, a source we all respect from the early and accurate analysis of the housing market decline. This conclusion is careful and nuanced, distinguishing a bottom in prices from a bottom in sales. Read the entire article, but here is the key takeaway:
And it now appears we can look for the bottom in prices. My guess is that nominal house prices, using the national repeat sales indexes and not seasonally adjusted, will bottom in March 2012.
I expect this to be an active topic of discussion this week and during the Spring. Any sign of life in housing would help the economy, and would provide some new sector and stock ideas.
About the Author
Jeff Miller has been a partner in New Arc Investments since 1997, managing investment partnerships and individual accounts. He has worked for market makers at the Chicago Board Options Exchange, where he found anomalies in the standard option pricing models and developed new forecasting techniques. Jeff is a Public Policy analyst and formerly taught advanced research methods at the University of Wisconsin. He analyzed many issues related to state tax policy and provided quantitative modeling which helped inform state and local officials in Wisconsin for more than a decade. Jeff writes at his blog, A Dash of Insight.